U.S. economy's finally back in gear

What next for GDP after Q3's anticipated strong growth?

WASHINGTON (CBS.MW) -- All the erasers on Wall Street are worn out from economists revising their estimates for third-quarter growth higher and higher.

When the dust clears, the economists' consensus forecast for U.S. growth could top 6 percent for the quarter, nearly double the 3.3 percent recorded in the second quarter and far ahead of the first quarter's 1.4 percent.

Six percent would be the fastest growth since the final quarter of the previous century, when 7.1 percent economic growth seemed rather pedestrian against a stock market that threatened to double in a year.

The government's first estimate of third-quarter gross domestic product will be released on Oct. 30.

The economic data calendar in the coming week is practically barren, with no major monthly releases scheduled. See Economic Calendar.

There's still no job growth, but almost everything else went right from July through September.

Unlike the second quarter's growth, which was led by the biggest increase in defense spending since the Korea War, third-quarter growth appears to be driven by balanced private-sector spending.

Boosted by a double-shot of fiscal and monetary stimulus, consumer spending shot ahead at the fastest pace in years. Businesses, while still cautious about hiring, were willing to spend money on new equipment, software and structures, the early evidence shows.

Economists had been expecting a good quarter, but its apparent strength left them gasping for words.

Apt descriptions

Growth was "stratospheric," said Goldman Sachs economists. Lehman Brothers' economists couldn't seem to settle on "extremely solid," "very strong" or "very vigorous." Citigroup reached back for a medieval metaphor and said growth was "catapulted."

"Consumer spending, business investment, and residential investment were also stronger than originally expected in the third quarter," said Maury Harris, chief economist for UBS.

With interest rates hitting four-decade lows in the early summer months and Uncle Sam mailing out checks to 25 million families, it was apparent that consumer spending would be strong. But not like this.

Consumer spending likely grew by about 6.5 percent to 7 percent in the quarter, said Bill Dudley, chief economist for Goldman Sachs. That would be the fastest growth in 15 years.

Consumers bought record numbers of homes and cars.

"Consumption is particularly strong, benefiting from a 'perfect storm' of positive tailwinds: lingering cash-out refinancing effects, tax cuts and a post-war boost to confidence," said Joe Abate, an economist for Lehman.

Those tailwinds are dissipating. Taxpayers won't get any more help from the tax cut until they file their 2003 returns next year. The mortgage refinance boom has mostly played out. And confidence seems to be stalled, waiting for the jobs to appear.

"Much of the third-quarter growth spike seems to be due to the temporary effect of the latest round of tax cuts," Dudley said. "We estimate that households have already spent around 75 percent of the third-quarter tax cut, a larger share that we had expected on the basis on past tax-rebate episodes."

Time for a downshift?

"The implication is that spending growth is likely to slow sharply in the fourth quarter, unless other sources of income growth accelerate sharply," Dudley said.

Without job growth and wage increases, most families won't be seeing fatter paychecks any time soon.

On average, inflation-adjusted weekly earnings are up just 0.1 percent in the past year while average real income from wages and salaries is down 0.1 percent in the past year.

The worry about the sustainability of consumer spending is the chief reason that Goldman's forecasting a GDP slowdown to 3 to 4 percent growth next year. "Growth is still not fast enough to get rid of the excess capacity in the economy," Dudley said.

Others remain optimistic that the economy will be fine next year.

"Household spending is at the heart of the ongoing demand revival," said Robert DiClemente, an economist for Citigroup Global Markets. "Consumer spending undoubtedly will slow from third quarter's breakneck pace, but favorable fundamentals will continue to underpin solid growth in the period ahead."

DiClemente figures the average household saved $80 a month from refinancing their mortgage. That's extra cash each month.

"Disposable income will remain well supported by tax cuts and the spillover from productivity to real wages," DiClemente said. And next year's tax cut is even bigger than this year's.

"By our estimate, disposable income will be boosted by roughly $170 billion in the first six months of 2004 versus about $120 billion in the second half of this year," he said.

Consumers may slow their pace of spending over the next few quarters, but businesses are expected to pick up the slack. Of course, we've been hearing that for more than two years now.

"The sharp acceleration in demand, along with expanding profit margins, is translating into impressive gains in corporate cash flow and laying the foundation for a fully self-feeding recovery," DiClemente said.

"With rising revenues and much less financial stress, businesses should rebuild inventories and increase employment, giving further momentum to economic growth," said Sung Won Sohn, chief economist for Wells Fargo "Significant hiring by businesses will be the final confirmation that sustained economic growth is here to stay."

"Growth in capital spending will be the development that takes a modest recovery and makes it something else: a full-fledged economic boom," said Ken McCarthy, chief economist for vFinance Investments. "Now, as business spending revs up, equipment makers will perform well."

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